What is a DCF model?
A DCF model is a particular kind of financial model used to value a business. DCF stances for Discounted Cash Flow, so a DCF model is just a forecast of an organization’s unlevered free cash flow discounted back to the present value, which is known as the Net Present Value (NPV).
Despite the fact that the idea is basic, there is actually fairly a bit of technical background required for every one of the segments represented above, so how about we separate every one of them into additionally detail. The fundamental building block of a DCF model is the 3 statement financial model, which interfaces the financials together.
What is unlevered free income?
Cash flow is basically the cash created by a business that is accessible to be spread to investors or reinvested in the business. In financial modeling and DCF analysis, the kind of cash flow that is utilized is most regularly Unlevered Free Cash Flow (likewise called Free Cash Flow to the Firm)– cash that is accessible to both debt and value equity investors.
Cash flow is utilized on the estates that it speaks to economic value, while accounting metrics like net income don’t. An organization may have positive net income however negative cash flow, which would undermine the economic matters of the business. Cash is the thing that investor truly value toward the day’s end, not accounting benefit.
Why is the cash flow discounted?
The cash flow that is created from the business is discounted back to a particular point in time (subsequently the name Discounted Cash Flow model), commonly to the present date. The reason cash flow is discounted come down to few things, for the most part outlined as opportunity cost and risk.
A firm’s Weighted Average Cost of Capital (WACC) speaks to the required rate of return expected by its investors. Thusly, it can likewise be thought as a firm’s opportunity cost, which means on the off chance that they can’t locate a higher rate of return somewhere else, they should purchase back their own shares.
To the degree an organization realizes rates of return over their cost of capital (their hurdle rate) they are “creating value” and on the off chance that they are procuring a rate of return beneath their cost of capital they are “destroying value”.
Investors required rate of return (as discuss above) usually identifies with the risk of the investor (utilizing the Capital Asset Pricing Model). Along these lines, the riskier an investment, the higher the required rate of return and the higher the cost of capital.
The more remote the cash flow are the riskier they are, and subsequently should be discounted further, in view of the Time Value of Money.